How to select the right debt mutual funds for your portfolio: Part 1

Retail investors in India still prefer traditional fixed income schemes to debt mutual funds. Some of my friends associated with the asset management industry attribute this behaviour to the lure of assured returns which traditional fixed income schemes offer. While preference for assured returns might be a factor, in my view, there is lack of awareness of debt mutual funds and their risk / return characteristics among retail investors in our country. Unfortunately, many financial advisors are not able to do a good job, explaining debt mutual funds to investors. Debt mutual funds offer great solutions for a wide variety of investment needs. In this blog post, we will discuss how investors can match debt mutual funds with their investment needs.

Investment needs

A financial advisor once told me that a prospective client wanted to get at least 12% assured returns for 5 years, without any risk. It is simply not possible. If you are looking for high rates of risk free return you may become a victim of Ponzi schemes, of which many abound in our country. In order to get higher returns, you have to take risks. However, a smart investor clearly understands investment risks and matches it with his / her investment objectives. The first step of any investment process is to clearly define your needs:-

• What is your investment tenure?


• What is your risk appetite (how important is capital safety versus growth)?


• What is your return expectation (do you want steady income or capital growth)

Please note that, all the three points mentioned above are interrelated, but we will discuss these three points separately, so that you are able to make the best investment decision.

Investment Tenure

• If you are investment tenure is very short, say less than 1 year, then you should go for money market mutual funds. These funds invest in money market instruments (e.g. treasury bills, CP, CD etc) with residual maturities ranging from 90 days to a year. Money market mutual funds offer high degree of capital safety and stability of returns. If your investment tenure is less than 3 months, then you can invest in liquid funds. Liquid funds have no exit load and redemptions are processed within 24 hours. Liquid funds gave around 3.2% average returns in the last 6 months and 7% average returns in the last 1 year. Purely from a returns perspective, investing in liquid funds is better than keeping money idle in savings bank account.


• If your investment tenure is 3 to 12 months, then you can invest in ultra-short term debt funds. Ultra-short term debt funds (previously known as liquid plus funds) are also money market mutual funds with residual maturity of less than a year. Ultra short term debt funds are slightly more volatile than liquid funds, but they also offer high degree of capital safety and stability of returns. Liquid funds have no exit load and redemptions are processed within 24 hours. Ultra-short term debt funds usually give higher returns than liquid funds. Ultra-short term debt funds gave around 3.7% average returns in the last 6 months and 8.3% average returns in the last 1 year. If you have money lying idle in your savings bank account for almost a year, you can grow your money in ultra-short term debt funds.


• If your investment tenure is 1 – 2 years, you can invest in short term debt funds. These funds invest in corporate bonds (NCDs) and government bonds with maturities of usually less than 3 years. Short term debt funds usually hold their bonds till maturity and hence the interest rate risk is low. Interest rate risk refers to risk of change in investment value due to change in interest rate. Bond prices are inversely related to interest rates; bond prices go up when interest rate falls and go down when interest raterises. However, bond price change is of no consequence to the investor if the bonds are held to maturity, because the bond issuer will pay the investors coupons (interest) at the promised rate, irrespective of whether current rates have risen or fallen. Short term debt funds gave around 3.9% average returns in the last 6 months and 9.5% average returns in the last 1 year.


• If your investment tenureis 2 years or more, you can invest in corporate bond funds or income funds. Corporate bond funds and income funds are different debt fund categories and investors should understand the difference between the two. Corporate bond funds invest in corporate bonds of varying maturities. Debt fund investors should know that, interest rate risk increases with bond maturities and therefore, corporate bond funds can be volatile in the short term. Corporate bond funds (also known as Credit Opportunities fund) gave around 4.5% average returns in the last 6 months and 10.7% average returns in the last 1 year.
  
  Income funds invest in corporate and government bonds of varying maturities. The underlying securities in an income fund have much longer average maturities compared to short term debt fund or even corporate bond funds. Income funds are highly sensitive to interest rate movements and usually work best in the long term over the entire interest rate cycle (rising and falling rates).
  
  We will discuss the risk / return characteristics of corporate bond funds and income funds in more details later in the post. Income funds (also known as Credit Opportunities) gave around 3.5% average returns in the last 6 months and 11% average returns in the last 1 year.


• If your investment tenure is 3 years or moreand you have no liquidity needs in the interim from your investment, you can invest in Fixed Maturity Plans (FMPs). FMPs are close ended debt mutual fund schemes. Close ended funds have defined maturity periods and investors cannot redeem the units before maturity. The interest rate risk in FMP is quite low because the fund manager holds the bonds in the FMP portfolio till maturity. FMPs have given around 8.7% average returns in the last 1 year. Investors can invest in FMPs only during the limited subscription window (at the time of offer). You can come to know about FMP offerings by following the news section on our website (please see Latest News on Mutual Funds). You can also get information of FMP offers in the AMFI website or websites of individual Asset Management Companies (AMCs).

Investors should make sure that their investment tenures are aligned with fund maturity profile if they want to reduce their interest rate risk. You can get information on the fund maturity profile of debt fund schemes in the monthly factsheets published by the AMCs. You can download monthly factsheet of all AMCs by going to our Form Download Centre.

Conclusion of this part

Pre-conceived notions prevent us from making the best investment decisions. Knowledge and objective thinking, on the other hand, enables us to make the best decisions. Many retail investors in India think that, debt funds are very complex while equity funds are easier to understand. In equity the investment objective is usually capital appreciation over a long investment horizon, whereas in fixed income, investors can have a variety of investment objectives, in terms of liquidity, investment tenures, risk and return preferences. The complexity in fixed income investment is in matching investment products with your needs. Once you are able to match product with your needs, investing in debt funds can be very simple and rewarding. In this post, we discussed how to select debt funds based on your investment tenure. In the second part, we will discuss how to select debt funds based on your risk preferences and return expectations. Continued to Part 2